Common mistakes to avoid during fundraising due diligence
Master fundraising due diligence and avoid mistakes with essential insights.
Potential investors and acquirers will conduct fundraising due diligence on a target firm after being impressed by the concept, business strategy, or structure to make a more educated judgment about whether or not to invest. If you’re reading this, you’ve already reached this stage. As an investor, you’ve found a business you’re interested in and feel like it can be a good return on investment. But you can’t just go with the word of owners. You must verify key data and metrics about the business. The due diligence process is usually the make or break for the deal between you and the startup.
By this stage, you should be well-versed in the process and its requirements ahead of time. While you should know what to do in this process, you must also be aware of mistakes to avoid in fundraising due diligence. This article will help you with just that.
Fundraising due diligence
The fundraising due diligence process will uncover a variety of information about a business. Legal and financial due diligence are two types of fundraising due diligence that will examine the company’s key assets, including its employees, finances, products, and ownership stakes. While the majority of the points will be universal, each investor needs to supply the target firm with a checklist to ensure that no details are overlooked.
Be ready and be alert of frequent mistakes investors make with fundraising due diligence to ensure a seamless process and to ensure you’re dealing with a solid opportunity. Before we get into that, let’s get the fundamentals out of the way first.
Understand fundraising due diligence
Due diligence refers to the process of thoroughly researching a possible investment. Investigating all financial information, the business’s prior performance, and any other relevant data may be part of this process.
The majority of businesses present what they have to offer to investors in a presentation and pitch deck, all of which summarize the possible investment. Here, the investor cross-checks the points made in the proposal through fundraising due diligence to determine if the company is a good investment or not.
This process initiates after the company’s founders and the investor sign the term sheet. The investor will provide a list of questions related to venture capital due diligence. This will tell startups the paperwork they’ll want, as well as what data and access you’ll need from them.
It might take weeks, even if the business has everything you need. It might take much longer if they’re yet to gather crucial papers or offer explanations for discrepancies in the data submitted.
Importance of fundraising due diligence
Any large investment requires thorough research, which explains why investors in a funding round have legal obligations for carrying out fundraising due diligence to safeguard their interests. This stipulation, which originates from the 1933 Securities Act, addresses the protection and responsibility of an underwriter’s attorney throughout the due diligence process.
In addition, investors’ safety should be a top priority during the fundraising process, making fundraising due diligence on the startup a crucial step. This gives them the information they need to assess the startup’s commercial viability. The goal is to instill trust in the company and its management among potential investors.
Fundraising due diligence checklist
Each investor will have their distinct way of carrying out the fundraising due diligence process and should provide you with their own set of requirements. However, these are a few things that all kinds of due diligence will demand. We’ve compiled a list of these things below so you can get a basic idea of what you might need:
- A record of all board and shareholder actions
- Minutes from their meetings
- Charter documents, such as company bylaws, certificate of incorporation, etc.
- All types of corporate legal documents
- Diluted cap table and documents related to equity distribution
- The agreement related to the intellectual property (IP) assignment
- Information about your employees and their offer letters
- Employee benefit plans
- Equity grant documents and data
- Data on debt deals and credit lines
- Information about external stakeholders
- 409a valuations
- Audited financial statements
- Annual budgets
- Insurance policies of directors and officers
Common Mistakes to Avoid During Fundraising Due Diligence
As an investor, when you conduct fundraising due diligence, you’ll have to go through several steps, such as carrying out research, collecting and reviewing documents, making site visits, checking references, and making analyses and reports.
During this process, there are certain mistakes that investors commonly make. These mistakes can not only delay the due diligence process but can also result in you making a wrong investment decision. To save you from trouble, we’ve discussed them below:
Lack of Focus
You cannot just carry out a fundraising due diligence process without establishing what you’ll have to focus on during the investigation. A lot of times, investors and their teams fail to establish clear goals for the due diligence process. This results in them not knowing what to expect from the outcome of this research and investigation. It also hampers the entire project process because, without a clear goal, they wouldn’t know what to look for and where.
Always go into a project with well-defined goals in mind, and know what specific outcomes you’re hoping to achieve. This aids in identifying where to focus your efforts, what information you need to gather, and how to guarantee consistency with the business’s broader plan. This requires asking yourself some deep questions about your motivations for conducting this research.
Once you’ve determined the goals, you’ll have to prioritize areas of investigation that are most likely to help you achieve your goals. Form a group of knowledgeable, experienced individuals to work on the review. Plan out who will do what and when so that the project may be completed successfully and on schedule.
Incomplete or Inadequate Information Gathering
Once investors have determined their focus, they need to make sure they get everything needed to complete the process by making a thorough fundraising due diligence checklist. A major mistake you can make here is not creating this checklist carefully. If you miss out on certain requirements or “forget” to ask for certain documents, you’re putting yourself at risk of letting go of some important details.
The first phase in the due diligence process is a discussion between the investor and the startup. The purchaser requests relevant papers for auditing, engages in conversation through interviews with the startup and its key staff, and visits the premises. The transaction will move forward more quickly if the startup is responsive and well-organized. Otherwise, the investing process might be made more difficult. Regardless of their attitude, you must not make the mistake of failing to conduct interviews with key staff and stakeholders, because you can get operational insights into the business. It can also reveal the dynamics between the staff and key members of the company.
Lack of Attention to Red Flags
Another huge mistake you can make during fundraising due diligence is neglecting certain red flags and warning signs. A “Red Flag” is material information discovered during legal due diligence that appears to be at odds with the norm or unusual, such as possible liabilities of the company being investigated that might pose hazards or dangers if left unresolved. This is a warning indicator that the corporation may soon be subject to legal action.
As you’re investing a good sum of money into the company, you can’t afford to fail to investigate the potential risks or concerns. Warning signs may appear in different settings. In the course of conducting legal due diligence, red flags often pertain to issues like lawbreaking, lawsuit, unpaid debts, etc.
Relying Solely on Publicly Available Information
Private companies are not subject to the same level of public transparency requirements as publicly traded companies. Public companies are audited more frequently to ensure compliance with the more strict business and accounting rules, such as GAAP and IFRS. This is why potential investors could investigate any publicly available data for public companies. However, you can’t make the mistake of taking the word for publicly available information and not doing further research.
A lot of times, investors look at numbers and decide against conducting site visits or other in-person investigations. The property may be overvalued if the underwriter is excessively pushy in their approach or if not enough comparable sales data is collected. Finance, sales listing, investment research, property insurance, and taxation all rely on accurate real estate value estimates. Therefore, an inaccurate site assessment might have far-reaching consequences for valuation.
Failing to conduct reference checks can also come at a cost. Reference checks can reveal significant discrepancies in the data and reveal important red flags and warning signs that may need your attention.
Over-reliance on Third-Party Reports
The fundraising due diligence report serves as the deal’s focal point. The deal and the valuation rest on this. Accordingly, it is crucial for the parties doing the due diligence study to make sure they have adequate expertise.
No matter how forthright the vendor may be, you should not count on them to reveal every flaw and weakness in the business. The onus of fundraising due diligence rests squarely on the shoulders of the investor. The most typical error is placing trust in the findings of third-party due diligence investigations. The investor might consult the approved vendor list maintained by banks and other financial organizations.
The goal is to have the acquiring company’s genuine situation laid forth in the fundraising due diligence report. So make sure you’re paying enough attention in reviewing all the reports provided to you.
Lack of Follow-Up
If you want a successful due diligence process, you need to collaborate with the startup on your findings. If you see potential in the business and are committed to investing, you can’t fail to follow up on any concerns or recommendations and update due diligence as circumstances change.
Any risks or potential bottlenecks that are discovered during fundraising due diligence, when communicated to the board and management team, you provide a chance to fix them. You may also offer suggestions for fixing the company’s problems so that the startup can take immediate action to speed up the due diligence phase of fundraising.
Intellectual property compliances
Intellectual property difficulties, which can vary greatly based on what the company offers, are the most prevalent and time-consuming hitches in due diligence. There could be delays in development caused by forgetting to plan for trademarks, patents, and licensing. These can have a significant effect on the company’s expansion. Having a skilled IP lawyer on hand is a good idea of whether or not legal assistance is needed to resolve IP concerns. This can help to fix issues as soon as possible is crucial.
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